Every month, many hedge fund managers grapple with a fundamental conflict of interest. The conflict arises when a fund manager, whose compensation is based on fund performance, is charged with determining the value of the complex or illiquid securities in his portfolio. These securities often do not receive reliable market quotes, and may be difficult to value. Accordingly, a fund manager may be tempted to misprice the hard-to-price names in his account in order to bolster fund performance, and increase his own compensation. The situation is somewhat analogous to a chief financial officer calculating his corporation’s profits, all the while knowing that his calculations will affect his bonus.
Change, however, is on the horizon. On Dec. 2, 2004, the United States Securities and Exchange Commission amended the Investment Advisers Act of 1940 to require certain hedge fund advisers to register with the commission (the “Rule”).1 Under the Rule, registered hedge fund advisers will be required to make their books available to SEC examiners by Feb. 1, 2006, and, in turn, subject their valuation methods and policies to regulatory scrutiny.
The Rule stems, in part, from the commission’s concern over a fund manager’s financial incentive to manipulate the value of the securities he manages in hopes of achieving better performance. The commission has recognized that “[h]edge funds may invest in highly illiquid securities that may be very hard to value,” and that managers often “give themselves significant discretion in valuing securities.”2 As a result, the commission has warned investors to “understand a fund’s valuation process and know the extent to which a fund’s securities are valued by independent sources.”3 In fact, the commission has cited the lack of independent checks on an adviser’s valuation methods as among their “most serious concerns.”4
Recently, the commission’s concern has translated into enforcement action. Over the past eighteen months, the commission has brought a string of actions against hedge fund managers and advisers, accusing them of deceiving investors by mispricing the value of their funds.5 For example, the SEC recently settled a case against Beacon Hill Asset Management, LLC, and its four principals.6 In Beacon Hill, the SEC filed a complaint alleging that the firm and its principals made material misrepresentations to investors concerning, among other things, the methodology Beacon Hill used for calculating the net asset values of its hedge funds, and the value and performance of the funds. The SEC also alleged that Beacon Hill fraudulently valued the securities in its hedge funds to support steady and positive returns. Ultimately, Beacon Hill agreed to pay a $2 million penalty and more than $2.4 million in disgorgement and prejudgment interest to resolve the case.
Similarly, the commission brought a settled case against Edward J. Strafaci, a former Lipper & Co. portfolio manager, for making materially false and misleading statements to investors about the value of the securities in his hedge fund, and the value and performance of the fund overall.7 In Strafaci, the SEC alleged, contrary to representations in the relevant offering documents and Strafaci’s own oral representations, that Strafaci did not value many of the Lipper funds’ convertible securities at or close to the prevailing market prices for those securities, as reflected by major market makers or recent transactions. Instead, according to the SEC, Strafaci priced significant portions of his funds’ convertible securities at prices substantially higher than the prevailing market price or the securities’ fair value. Ultimately, Strafaci was barred from the securities industry. He had already pleaded guilty to one count of securities fraud in a separate proceeding.
Given the SEC’s recent attention to valuation issues,8 and in light of the impending registration requirements, fund advisers should examine their valuation policies and procedures in an attempt to cure any deficiencies in pricing complex or illiquid securities. Set forth below are three recommendations designed to help advisers in this pursuit.
Three steps a hedge fund adviser can take to guard against unfair or deceptive valuations include (A) implementing firm-wide policies and procedures designed to promote consistency in the valuation process; (B) if possible, limiting the fund manager’s involvement in the valuation process; and (C) properly disclosing valuation policies and procedures to clients.
A. Policies and Procedures
The first step an adviser can take to minimize the risk of mispricing is to implement a clearly defined set of valuation policies and procedures. A recent survey conducted by PricewaterhouseCoopers revealed that only about half of hedge fund advisers maintain detailed valuation procedures,9 even though such procedures are likely to be the starting point for SEC examiners during their inspections.10
In general, valuation policies and procedures should be drafted to promote fairness and consistency in the valuation process. They should be reproducible, transparent and verifiable.11 More specifically, they should clearly indicate the methods, principles and models that a manager may use to calculate the value of his investments, especially hard-to-price investments such as convertible bonds, mortgages and mortgage-backed securities, credit default swaps, over-the-counter derivatives, bank debt and loans, emerging market securities and micro-cap securities.12 The manager’s goal should be to arrive at a fair NAV for the fund in accordance with generally accepted accounting principles or GAAP.13 In addition, deviations from, or exceptions to, the valuation policies should be well documented and disclosed to clients.
Fund advisers may also consider forming a pricing committee to address the difficulty in valuing illiquid and complex securities. The PwC Survey found that only 37% of the survey group had formed such a committee.